Chapter 8: Behavioral Finance

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Transcript of Chapter 8: Behavioral Finance

Economics assumes that individuals are rationalBehavioral FinanceChapter 8: Behavioral FinanceSuppose investor purchase 100 shares of ATT for $33 per share.Investors are more likely to sell "winners" than sell "losers"Representative Heuristic - if something is random, it should look randomHeuristic: Using a rule of thumb for making a decision.Technical Analysis - using past price data and other non-financial data to identify future trading opportunities. Technical AnalysisThree forces at work in the market:You receive a letter from the IRS that says you overpaid on your taxes and that you are going to get $500 back.Prospect TheoryHow will you invest the money you earned versus the money you found on the sidewalk?1. Study behavioral finance - learn when you are most likely to make an investment mistake.Behavioral FinanceHow do we overcome bias?Dow TheoryFooled by RandomnessHeuristics and HerdingLoss AversionLoss Aversion and InvestingCompare benefits and costBehavioral finance - combines psychology with economicsDecision-making is more complicated - emotions impact how we make decisions.Identified instances when people are likely to deviate from rationalityYou receive a letter from the IRS that says you underpaid on your taxes and that you owe an additional $500. Lesson: individuals view gains and losses differently.Scenario 1: You have $1,000. You have the following choice:a. You can receive another $500 for sure.b. You can flip a coin - heads you get another $1,000; tails you gain nothingScenario 2: You have $2,000. You have the following choice:a. You can lose $500 for sure.b. You can flip a coin - heads you lose $1,000; tails you lose nothing.85% of people choose A in scenario 170% of people choose B in scenario 2But...Option A and Option B are identicalOption A = $1,500Option B = 50/50 chance of $1,000 or $2,000Lessons:1. Individuals are not likely to consider the total wealth of their portfolio (focus on gains and losses)2. Frame dependence: How an individual decides something depends on how it is presented to them.3. Use a broad fram when thinking about investing (overall wealth) rather than a narrow frame (changes in wealth).$33 is an important price to the investor. $33 becomes an anchor.What if ATT falls to $25? Will the investor sell?Selling stock - breaking up with someone/firing someoneRather than sell, I'll just hang on to the stock until it reaches $33The stock doesn't know you own it. You have feelings about it, but it has no feelings about you. The stock doesn't know what you paid. People shouldn't get emotionally involved with their stocks.I'll do some thinking about this stock...

If I would buy at $25, then I will hang on to the stock. If I wouldn't buy, then I'll sell.You are pretty sharp. Why don't you send me your resume?An investor with 100 stocks that are "winners" is likely to sell 15 of them.An investor with 100 stocks that are "losers" is likely to sell 10 of them.Mental AccountingEarned through hard workFound on the sidewalkMental Accounting - segmenting money into mental "buckets" - earned money versus windfall earnings.Casinos - people take bigger gambles with their winnings - House money effect.Myopic Loss Aversion-Avoid short term losses (fail to invest in stocks for retirement)Regret Aversion - Avoid making a decision (buy or sell) because you fear that you might regret the decision later.Sunk Cost Fallacy - throw good money after badEndowment Effect - consider something you own to be worth more than you would be willing to pay to acquire itMoney Illusion - ignoring inflationOverconfidenceWho gets a higher return? those who trade a lot or those who trade less frequently?brokerage firm - households that traded less frequently earned a 16.4% return; households that traded frequently 11.4%. Illusion of Knowledge - belief that your knowledge is superior to other investors. GM management said that shares are worth $0, yet people still bought and sold shares of GMForecasting ErrorsHot Hand fallacy - If Lebron James just made three jumpers, what is the probability that he will make the next?Clustering Illusion - if heads comes up four times in a row, then it must not be random.If a mutual fund has three good years in a row, is it a good investment?If a stock has made a nice run, is it likely to continue going up?Gamblers Fallacy38 numbers2 green18 red18 blackSuppose red comes up 5 times in a row. Is the next spin more likely to be black?If a stock has 4 bad quarters in a row, is the next one likely to be good?1/n phenomenon - Investors use this rule of thumb for deciding how to allocate money among investment choices.Herding - following the crowdInvestment analysts - if everyone says that a stock is a good buy, and your analysis says to sell stock, what would you recommend?2. Precommitment - Try to avoid making decisions when emotions might influence your decision-making. Set up automatic withdrawal from checking account for investments.Market sentiment = # of bearish investors# of bearish inv. + # of bullish inv.Survey 100 people - 20 bullish, 80 bearish; Market Sentiment = 80/(80+20) = .8Contrarian indicator - if it is high, technicians believe that the market is "oversold"; if it is low it is "overbought"1. Primary trend - overall direction the market is going.2. Secondary Trend - deviations from primary trend3. Daily fluctuationsDow Theory - an indicator for predicting market directionDow TheoryMonitor the DJIA and DJTAIf one departs from primary trend, the movement is viewed as secondary.If one of these departs from the primary trend and the other departs from primary trend, then it is viewed as confirmation that the market is changing.Support and Resistance LevelsInvestors think it has hit the top and sellInvestors think it has hit a low and buyMarket Diary